Making sense of dynamic bonds

if investors looking to take advantage of higher returns in the fixed income space, could consider gilts or govt. bonds as an investment option. As discussed earlier, every bond is a debt contract and for a smooth execution it must address the credit risk. Credit risk is an event when the borrower (bond issuer) turns insolvent i.e., bankrupt, unable to pay the principal amount to the bondholders.

Conservative savers or investors love higher interest rates. It allows them to earn higher return on their fixed deposits or other fixed income avenues. Though economically, higher interest rates indicate a higher inflation and could create headwinds for growth, they also provide these investors with possibility to earn higher returns though mayn’t always translate into higher real returns. Real return is the return or interest earned negated by the inflation. After a steep increase in interest rates by the regulator, the Reserve Bank of India (RBI), has kept the rates unchanged almost for a year. Though the inflation has been persistent, it has turned benign in the last few months. The international geo-political situation, however, hasn’t helped RBI to make any moves to cut the rates. Moreover, the US Federal Reserve (Fed) has been on a tighter leash on the rates and continued their tightening stand. Such an aggressive stance by the US Fed leaves not just India but all other markets in a tight spot as the US dollar (USD) hardens (due to inflows attracted into US considered or perceived as safe haven). The strengthening dollar adds further pain to the central bankers trying to rein in inflation in their economies. Overall, the RBI has managed to juggle this well in the last couple of years, notwithstanding the turmoil in the middle east and continued Ukrainian war.

As the inflation remaining in control and growth thrusters getting exhausted, it’s just a matter of time the central banks begin to let loose their purse strings. A few central banks like that of Brazil and Switzerland have begun their cuts ahead of the US Fed.

There’s a talk gaining in the circles that the European Union (EU) is also gearing up for a rate cut for the region in their next policy meeting of June.

Though, these signs are evident, the geo-political situation has remained volatile and hence the bond yields exhibiting higher fluctuations. For every bond i.e., a contractual debt obligation, an interest is to be paid or simply said as coupon. The coupon is same and constant across the bond period but the bond price varies in the market depending upon the demand. For instance, in a falling or lower interest rate scenario, the bond prices usually go up if the coupon offered on the bond is higher than the available interest rate.

This is because investors looking to eke out higher interest for the same principal would scout for a bond which offers higher interest. As more investors flock towards a particular bond, the price shoots up. But as the interest or coupon is same for the bond irrespective of the purchase price, the net return would be lower than the coupon in percentage terms. This return on bond is called yield and it is inversely proportional to the bond prices i.e., if the bond prices go up, the yields come down and vice versa. This usually also portrays the possible expansion and contraction phase of the economy. Thus, the bond yields indicate the possibility of a recession, etc. in an ideal market economy.

So, if investors looking to take advantage of higher returns in the fixed income space, could consider gilts or govt. bonds as an investment option. As discussed earlier, every bond is a debt contract and for a smooth execution it must address the credit risk. Credit risk is an event when the borrower (bond issuer) turns insolvent i.e., bankrupt, unable to pay the principal amount to the bondholders. Govt bonds or gilts are thus considered as the safest investments with no default risk. Gilt funds are a choice to invest in these through Mutual Fund (MF) route.

These bonds are usually for longer duration i.e., longest one running into multiple decades, are however, subjected to short term volatility due to the changes in the govt policies, currency fluctuations, geo-political environment, etc. Most risks are macro and beyond an investor’s control so these funds though on prima facia appear to be risk-free does associate with higher volatility. But, if one could time it to perfection, could benefit from the higher returns. Investing in these bonds or funds get to enjoy not just the interest accrued by the bond but also the gains from the change in the bond prices (when traded). This capital gains along with the interest income could be higher than the pure interest components of a fixed deposit, etc. One thing however, investors should keep in mind is that capital preservation forms the basis of allocation to fixed income for conservative investors. And the short-term volatility could cause a dent in the investors’ portfolios.

While timing is possible, is a difficult decision. Moreover, the bond markets mostly- discount or price-in the changes. Instead investors could mix these bonds with high- quality short-duration debt instruments or funds to counter the volatility. These dynamic bond funds try to offer the best of the both worlds thus making money while reducing the risks. One must remember that taking risky bets is detrimental to the very purpose to pursue debt investments. So, investors should be vary of the risk and not just look at the returns while investing in these funds.

The author is a “co-founder” of Wealoticy, a wealth management firm and couldbe reached at [email protected]